Friday, January 13, 2017

The $30k Hypothesis

I wrote a Bloomberg View post about the Permanent Income Hypothesis. Basically, more and more research is piling up showing that it doesn't fit real consumption patterns. Some consumption smoothing takes place, but there's also a substantial amount of hand-to-mouth consuming going on. Most economists I know of have already accepted this fact, and usually chalk the hand-to-mouth behavior up to liquidity constraints (or, less commonly, to precautionary saving).

But a new paper on unemployment insurance extension casts major doubt on these standard fixes, especially on liquidity constraints as the culprit. A long-anticipated transitory shock - UI expiration -- shouldn't produce a big bump in consumption even if people are liquidity constrained. Nor is home production the answer, since unemployed people are already at home long before UI expires. Something else is going on here - either people interpret UI expiration as a (false) signal of the expected duration of unemployment, or they expected Congress to extend UI at the last minute, or they're just short-term thinkers in general. Or something else. I predict that as more and more good consumption data become available, more and more of this short-termist behavior will be observed, putting ever more pressure on people who use standard models of consumption behavior.

Anyway, as expected, some people came out to defend the good ol' PIH, including my friend David Andolfatto, one of the web's best econ bloggers and a ruthless enforcer of Fed dress codes. David's claim was that the PIH is still useful in some cases, and not in others.

That's fine...IF we know ex ante what the cases are. If it's just an ex post thing - "consumers look like they're completely smoothing in this case, but not in this other case" - then the theory has no predictive power ex ante. How do you know if consumers are going to perfectly smooth in advance, if sometimes they do and sometimes they don't, and you don't know why? Liquidity constraints, which we can probably observe, are one reason to expect PIH not to hold, but they're only one reason - as the Ganong and Noel paper shows, there are other important reasons out there, and we don't know what they are yet.

Here's an example of why I think we can't just be satisfied with the notion that theories work sometimes and not others. Consider a very simple theory of consumption: the $30k Hypothesis. Stated simply, it's the hypothesis that households consume $30,000 a year, every year.

Rigorous statistical tests will reject this hypothesis. But so what? Rigorous statistical tests will reject any leading economic theory, especially as data gets better and better. All theories are wrong (right?). Some households do consume $30k, or close to it. So the $30k hypothesis is obviously right in some cases, wrong in others.

So should we use the $30k Hypothesis to inform our policy decisions? How should we know when to use it and when not to? Judgment? Plausibility? Political expedience?

This is a reductio, of course - if you don't impose any systematic restrictions on when to use a theory, you become completely anti-empirical, and priors rule everything. This is also why I'm a little uneasy about Dani Rodrik's idea that economists should rely heavily on judgment to pick which model to use in which situation. With an infinite array of models on the shelf, economists can always find one that supports their desired conclusions. I worry that judgment contains a lot more bias than real information.

23 comments:

I dislike explanations that presume clairvoyance. Personally I would say what is changing is people's expectations of increased length of unemployment and lower income when/if re-employed. What is changing is the future and we don't always know what is in store.

I'm not an economist by training or education ( education wise, one would say statistics is my training ) but I've been teaching myself econometrics-economics and doing tests of rational expectations seems to be one way to test economic theories. just want to hear back from the trained folks on the pitfalls behind this approach. thanks.

I don't think your 30k example is a good counter to the PIH. Your 30k hypothesis is an unconditional one. On the other hand, the PIH makes a conditional claim: If agents are perfectly rational, then consumption depends on permanent income, i.e. consumers smooth the (MU of) consumption.

If we completely do away with perfect rationality, we will not have the PIH, and suppose we then get that for whatever behavioral aspect that is relevant to consumer behavior, consumers reduce C when there is an anticipated fall in Y. Then, this suggests to me that tweaks to the PIH, e.g. adding liquidity constraints, are insufficient, and behavioral aspects need to be added. This also further suggests that people are not perfectly rational, which was no surprise to economists anyway. However, what this does not suggest, is that there is no PIH, unless one interprets it too literally (saying that the Euler doesn't hold mathematically). Between taking a position that people are perfectly rational and perfectly irrational, there could be many behavioral aspects of human behavior that outweigh the rational response (PIH-consumption smoothing), and so we observe something that seems like a rejection of PIH but isn't.

My point is the following: The PIH is "derived" conditional on perfect rationality. So unless one can control for perfect rationality and other behavioral aspects (which we cannot), not to mention liquidity constraints etc., we can never really falsify this theory. At best, we can show that behavioral aspects that matter for how (anticipated and unanticipated) changes in Y affect C matters much more than the PIH. This does not mean ditching rationality is a great idea. After all, we are all at least somewhat rational aren't we?

This is what Andrew Gelman refers to as "continuous model expansion": when we have a model that works well in some subpopulations, but we find evidence against it in other subpopulations, we need to expand to a super-model that reduces to the original model in the subpopulations where it works, while amounting to a different model in other subpopulations. What we want is not simply to toss the consumption smoothing model, but instead to generalize it in a way that retains its empirical successes, while making up for its empirical failures. If PIH does seem to apply in some settings, but not in others, that cries out for explanation, not dismissal of the model altogether.

The first question economists should ask themselves is what are models for.Currently, it looks like economists specialize in impressing the powerful in how sophisticated their tools are. it would be entertaining except they do have impact on what the powerful do, as we can see from the recent mandarization of policy making.

The problem with their highly sophisticated astrology is that, they, pretty much without exception, think that the point of models is to reduce bias. That's not the point. Curve fitting is fun. Lots of great math to play with. However, the point of models is to improve conditional expectations aka obtain information. If your model does not improve those, it's garbage.Yes, reducing bias can contribute, but it comes at a price. The more sophistication, the more variance you are going to incur in small samples. Given that in policy relevant questions, you deal, by and large, with small samples pretty much exclusively, parsimony is job one.The whole discussion about PIH is as always with those things totally misguided. It doesn't matter if it is false or true. A false assumption can work better than a true fact. In small sample inference it's optimal to throw away information. In other words, the question you should ask is what role the assumption plays in your model. You never let data do the math for you. You need to understand the mathematical structure of your model first and only use it if it asks simple questions of the data.

You people should really try and educate yourselves about the basics of pattern recognition. I know incentives go the other way, but i can't understand how people can live with themselves just producing lots of garbage. Is power sufficient compensation for living basically a lie?The profession should really think hard about what the whole point is.

Actually, I was hoping to avoid getting dragged into blogosphere debates this year, but your bloomberg article is a total misprepresentation of current view on PIH and the consumption function among macro theorists. Fridman was never a proponent of the caricature PIH version with quadratic utility which is now by more of pedagogical device/strawman. See for example here,http://www.econ2.jhu.edu/People/CCarroll/atheoryv3JEP.pdf. The modern view is centred on the buffer stock/precautionary saving model, in which future income expectations still matter for households that are richer or less likely to lose their job, with current income becoming more important at lower income. As a coarse approximation to this, more aggregate DSGE models use a 2 household type approximation where some households follow a version of the PIH (though even there the plausible assumption of consumption-work complementarity can lead to closer consumption-income tracking) while others follow a rule of thumb of consuming most of their income. The main IMF fiscal policy model below also implements finite planning horizons for the PIH households, but that's more rare:http://www.michaelkumhof.weebly.com/files/theme/working/gimfwp1034.pdf

The paper you cite and others show that rational precautionary saving behaviour can't fit all the facts. But this doesn't mean the model should be laid to rest. Rather, it argues for a combined model in which decision making is partially based on rational factors and partially on behavioural factors such as inertia or inattention, or anchoring to a default, e.g as in Gabaix' recent papers on sparse max. But why sensationally say that Friedman's theory has been laid to rest, when no one has been arguing for many years now (definitely not Friedman), that permanent income should be the only argument in the consumption function. "Laid to rest", would be to conclusively prove that e.g the coefficient on future income expectations can be set to zero in a consumption function, which is much harder or more unlikely (though it may depend on your priors).

The paper you cite and others show that rational precautionary saving behaviour can't fit all the facts. But this doesn't mean the model should be laid to rest. Rather, it argues for a combined model in which decision making is partially based on rational factors and partially on behavioural factors such as inertia or inattention, or anchoring to a default, e.g as in Gabaix' recent papers on sparse max.

Agreed.

But why sensationally say that Friedman's theory has been laid to rest, when no one has been arguing for many years now (definitely not Friedman), that permanent income should be the only argument in the consumption function.

Good question. Several reasons:

A) It gets normal folks to pay attention to stuff like this, which is a lot harder than you may realize.

B) A lot of people have only taken undergrad classes, and only know the caricature/pedagogical version.

C) A lot of models continue to use standard consumption Euler equations without liquidity constraints or buffer savings, and this may be affecting their results more than they realize.

Re C), agreed that everyone writing down macro-models with policy or forecasting pretensions should incorporate at a minimum credit constraints or partial rule of thumb behaviour. Re the other stuff, why does a) require you to give the public such a distorted perspective of current macro research and analysis? Sure people do that with econ 101 you like to complain about, when they make simple arguments against things like the minimum wage or against immigrants as reducing wages of low skilled workers. But my impression that you and others sometimes end up doing the same thing with some sort of behavioural econ 101 (which could be summarised as "people are stupid"?) in which you replace one kind of oversimplification with another one.

why does a) require you to give the public such a distorted perspective of current macro research and analysis?

That's a "Have you stopped beating your wife?" question. The truth is, I haven't given the public a distorted perspective of current macro research and analysis. I quite clearly wrote the following:

"Economists have known for a while that this theory doesn’t fit the facts. When people get a windfall, they tend to spend some of it immediately. So economists have tried to patch up Friedman’s theory, using a couple of plausible fixes. People might respond to temporary income changes because they’re unable to borrow -- if you want to spend more, but you’ve maxed out your credit cards and your home-equity credit line, a windfall from the government might free you from the tyranny of the bank. Lots of economists view credit constraints as a simple, minimally invasive way to save Friedman’s basic idea."

I read your post, but I'm not sure the de facto new baseline precautionary saving model is just a minimally invasive patch. The people who developed it certainly thought of it as very different from the simple PIH model. The unifying aspect of all these models isn't the response to permanent income. It's the development of a consumption function from dynamic optimisation subject to constraints. I guess, from that perspective I could agree with the last sentence of your column from that perspective, if we consider behavioural modifications a major overhaul.

Careerism notwithstanding, my concern is that macro awaits its James Clerk Maxwell - someone who can unify the several partially successful (local) models into a unified theory. Otherwise, macro just comes off as a mess of epicycles.

I can only speak for my part of physics by way of comparison, but macro sure seems to suffer from cults of personality and far too many research groups holding strongly to ill-justified priors.

That leaves me pessimistic that the economics community can actually produce it's own savior. Perhaps some new blood from ecology or epidemiology or elsewhere can rescue macro.

I think it is being more difficult for individuals to predict their permanent income because the job market is more unpredictable than when PIH was introduced. The unpredictability (especially when seeing information that states people are out of work for x years and not receiving $x) and people in general being risk averse shifts the consumption the way the data indicates. With information not as readily available via internet, I'm not sure the effect it would have on the same data.

"the drop in spending from UI onset through exhaustion fits the buffer stock model well, but spending falls much more than predicted by the permanent income model and much less than the hand-to-mouth model. "

My own prior is that most US graduates who are hired at or above the ~$50k/yr median wage do not collect more than 6 months of UI up thru age 55. Around 95% of such grads -- and for them, a PIH only fits their consumption data pretty well. Also Rational Expectations.

Contrarily, those without college degrees are subject to far more periods of UI, as well as longer times spent on UI. More of them conform to Hand-to-Mouth expectations, perhaps even up to 60% or so.

With others, including grads hired at lower wages (like working for Starbucks!) being a mix of PIH and Hand-to-Mouth.

I'm now thinking about materials science, and the difficulty of studying the properties of heterogeneous combinations, like combinations of wood, glass, & rock mixtures, where the reactions to any stress test are heavily dependent on the proportions of the particular material.

Macro models fail to predict aggregate behavior well because the real-world tests performed on the inevitably heterogeneous population produces disparate behavior by the various types of people in different situations.

From their paper "the buffer stock model fits better than a permanent income model or a hand-to-mouth model" <<

On the 11% drop in spending after UI exhaustion: "familiesdo not prepare for benefit exhaustion " <<

I'm pretty sure a big reason for this is the expectation by the worker, willing to work and looking for wort, that they will, in fact, get a job. Even if more than 50% fail to do so in the last 2 months of UI, or first month w/o UI, it's not certain that holding the expectation of a successful job hunt is irrational.

To be successfully hired, one usually needs to believe that one WILL be hired. Even if from a macro model point of view this belief is statistically falsified, at the individual level, those who believe more strongly that they will be hired will be hired at a higher rate than those who believe their chances follow the statistics.

Medical treatment has records of how, when a treatment has a 50% rate of success, the individual success rate can be influenced by the doctor: a) "this is somewhat risky, but most folks pull thru with this treatment, and I expect you will be able to, as well", vs b) "this is somewhat risky, about 50-50".So when the doctor is honestly saying the statistics (b), the level of survival is only 40%, but when the doctor is optimistic (a), the survival rate is 60%.(second try)

I have to say I find this "refutation" of the hypothesis to be baffling. I'm not an economist - but I don't see how the findings of this study refute any predictions I'd expect from the (wikipedia version) of the PIH. As far as I can tell, the PIH seems to be proposing a model of income allocation - spending versus savings, not absolute spending. In the study, they're looking at a point in time where unemployment benefits end - that is, income has gone to zero (actually probably below zero, since these people likely have debt obligations). So there's no income to allocate.

BTW I'm not taking a position on whether the PIH is "correct" or not - just noting that the question it seems to be addressing is "if you give George $1,000, will he spend it or save it?" and it hypothesizes that George's answer will depend on his estimation of future earnings, not just present earnings. Fine. So, if give George $1,000 and he spends $500 and saves $500, we might conclude based on this model that if we gave him $2,000, since his lifetime income estimates haven't changed he'll therefore spend the same $500 and save $1,500.

What this study is saying is that if this hypothesis is true, then if we give George nothing, then he should still spend $500 of that nothing, and he should save (-$500) of the nothing (i.e., borrow), and since these people didn't do that the hypothesis is therefore disproved. However, that premise doesn't follow from the scenario we're modeling.

In real life, people take on long-term spending obligations (their "monthly nut") based their immediate and long-term prospects for repayment. When George lost his job, he used the UI money to help meet those obligations, and he cut back on his short-term discretionary spending - e.g., he stopped going out for dinner. As he realized his benefits were going to expire before he was going to get a new job, he began cutting back on his longer-term obligations as well, e.g., he cancelled his cable TV, but he leases his car so he can't get out of that until the lease expires.

In the first few months, he used his credit cards so his savings rate was negative (i.e., he was borrowing) but as UI expiration approached his was able to cut back on this borrowing, so yes, he "saved more" in that his "savings/borrowing" payment went from, say ($1,200) to ($800), but he doesn't have enough income for his savings/borrowing payment to be positive.

One more thing. If I understand the original premise correctly, it's asserting that the PIH says that at any given point in time, a person has some fixed estimate of their total future earnings (e.g., "I will earn $1,500,000 over the next 40 years") and makes a spending decision based on that number. Therefore, if a person chose to spend $X in January, based on this model he should still choose to spend that same $X in July, independent of any changes to his income. As the study showed that the spending levels did change, the conclusion is this model is therefore false.

Of course - that's not at all how it actually works, and if that's actually what the PIH predicts, well, then it's clearly wrong. (but I suspect that's not what it actually predicts) First, people don't base their spending decisions on an estimate of total lifetime income - they incorporate a time/value discount. It is pretty easy to demonstrate that people don't value $100,000 in 20 years as much as they value $100,000 today, right?

Further, there's no reason to assume that this estimate is fixed - that you decide this number when you turn 18 and nothing that happens in your life will change it. Rather, people must be continually re-evaluating that number as present circumstances change, discounting the effects of those changes per the well-established principles of the time/value of money.

That is, a rational person will come up with a different estimate of the present value of their potential lifetime earnings given changes in their circumstances - one number when you're 18 and have been accepted to a prestigious university, another when you're 21 and just got hired for some new job with (you assume) potential for growth, yet another when you're 30 and laid off from that job, and still another when it's six months later, the benefits have run out, and you still see no prospect of getting a new job.

I suppose I'm talking to myself here, but to address Noah's concern regarding models that don't have any predictive value, I think it would be pretty straightforward to frame what I've described above as a model that, if it's valid, would have predictive value and would likely account for both the Keynes ("they'll spend it") and non-Keynes ("they'll save it") scenarios.

Specifically, this seems kinda obvious, but I would suggest that the impact of a change in income on a consumer's spending/saving behavior will depend on that person's estimate of their "Permanent Income Curve" AFTER adjusting that curve for the impact of the income change itself.

That is, if the income change is not sufficient to "bend the permanent income curve," then they'll behave as per the PIH. (i.e., limited impact on spending) If the income change is of sufficient size and duration that it actually changes the slope of the curve, then they'll behave in a Keynsian manner (i.e., strong impact on spending). I would expect that there's some empirical way to determine what a "sufficient size and duration" would be - that research would yield some formula that would be predictive and testable.